Part four of our coverage of the ANZ report Greener Pastures: The Global Soft Commodity Opportunity for Australia and New Zealand

ANZ has released a major Report (.pdf 13MB) detailing the opportunities for Australia and New Zealand for agricultural commodities over the next 30 years.

Gareth Vaughan discussed the Report's finding with ANZ's Graham Turley.

Over the next few weeks, we will take a closer look at what the Report finds for New Zealand. This week we look at the current state of agriculture in New Zealand and Australia.

ANZ's report finds that a global race is emerging to develop high potential agricultural opportunities.

Successful agricultural industries do not happen by accident but take many years of development to build complementary strengths across a number of areas.

The Asia Pacific region has fostered many successful agricultural industries in recent decades including Australian cotton, New Zealand dairy, and Malaysian and Indonesian palm oil.

The following is an extract of part four of the full Report focussing on the New Zealand aspects.

The current state of agriculture in New Zealand and Australia

KEY THEMES:

- Many Australian and New Zealand agricultural industries have lost momentum over the past decade.

- Major growth engines in Australia have stalled while New Zealand is heavily reliant on a single, large industry.

- Agricultural industries in both countries are at risk of losing international competitiveness.

- Serious challenges need to be addressed to enable Australia and New Zealand to capture the full extent of the opportunity.

Despite the massive opportunity for Australian and New Zealand agriculture, serious growth-constraints exist in these industries today. The first section of this chapter provides an overall assessment of agriculture in both countries. The remaining part outlines the current barriers to success.

Loss of focus on driving competitiveness and long term growth

It is easy to blame the drought for the poor performance of Australian agriculture in the past decade. At the same time, the success of New Zealand’s dairy obscures the mixed performance of some of the country’s other agricultural industries.

Rising exchange rates in both countries and surging global commodity prices have also made the sectors’ performance more difficult to judge.

In reality agriculture in both countries has, to varying degrees, lost momentum and there are a series of hurdles to overcome in order to secure the sector’s international competitiveness.

Australia needs to address serious challenges and re-establish growth engines

Australian agriculture in the 1980s and 1990s was extremely promising. While volume growth is not the only measure of performance, it is a significant one, and the final two decades of the 20th century saw rapid growth in agricultural production: both domestic and export volumes increased by about 3% per annum.

In contrast, performance over the past decade has been disappointing.

Serious underlying issues were already emerging in Australian agriculture before the turn of the last century:

- Productivity growth was already slowing in major industries.

- Farm performance varied enormously and many made little or no profit, limiting the ability of farmers to prepare for adverse situations.

- Skill shortages54 and succession issues were already evident, as median farmer age rose from 44 in 1981 to 50 by 200155. Median farmer age is now around 53.

- Capital required by farms was largely sourced from (and constrained by) bank debt and internal farm equity, with few alternative external sources available.

These issues were left unaddressed as Australian agriculture entered the first decade of the 2000s with unfavourable climate conditions and a rising exchange rate.

Australian agriculture shifted to short-run thinking to deal with short-term threats, while serious issues intensified. Farmers focused on profit protection rather than investing in growth as capital limitations saw debt levels surge and confidence plummet.

Today, many of the inhibitors emerging in the 1980s and 1990s have become constraints on future growth. These issues not only limit Australia’s ability to respond to the Asian opportunity; they also weaken the sector’s resilience – its power to withstand future climate impacts. Australia risks losing international competitiveness, particularly as costs across supply chains increase.

Without the removal of major constraints and a focus on productivity and higher returning products, it cannot be assumed that the return of favourable seasonal conditions will allow Australian agriculture to re-establish the growth trajectories of the past.

New Zealand agriculture: a two-speed sector

While New Zealand has fostered a highly successful dairy industry, the momentum has not been replicated in all agricultural industries. Despite steady growth in the 1980s and 1990s, overall agricultural production volumes remained flat for most of the past decade with few material signs of value growth independent of increases in commodity prices (Exhibit 4.1).

New Zealand agriculture resembles a two-speed sector that is heavily reliant on a single large industry. Much of the growth has been driven by dairy and small industries such as kiwifruit and wine (Exhibit 4.2).

Dairy increased its gross output value by more than 9% per annum over the past decade and contributed to almost half of the nation’s farm output in 2011. This strong growth has been offset by declines in other areas, particularly in the red meat industry, which has seen its share of total farm output decline from 37% in 2000 to 27% by 2011.

Despite some price-driven growth in output value, the production of lamb, beef, deer and live animals have all had volume declines. This shift has followed sustained profitability declines in red meat farming, driving land conversions to other uses such as dairy and forestry. Similarly, other industries such as poultry, pig and wool have also performed poorly delivering flat or declining volumes compared to earlier in the decade.

The strong leadership and operational strength characteristic of the dairy industry has generally not been carried across New Zealand agriculture.

The red meat industry has suffered from coordination challenges and misalignment between farmers and processors, resulting in a cycle of declining profitability. A handful of medium-sized processors are increasingly forced to compete aggressively in two markets in order to gain sufficient supply and differentiate in end-markets, while it’s difficult for farmers to be confident to invest where there are confusing market signals from processors. Strong leadership is required to drive future growth of the industry, which includes defining and evolving its position in the global market. Gaining sufficient scale is also important for many industries outside of dairy to compete effectively in global markets.

Sector-wide challenges, similar to those impacting Australia, also persist: farm debt levels have surged; capital constraints are growing; the labour force is ageing; and skill shortages are becoming a major problem. While the dairy industry is better placed than its peers, it is not free from its own set of hurdles including constraints in raising capital for downstream investment, markedly high farm debt levels, environmental concerns around increased nitrogen levels, and rising production costs, partly driven by a shift to higher input systems, which places increased risk on margins during unfavourable price volatilities.

Like Australia, agriculture in New Zealand will need to deal with sector-wide and industry-specific challenges in order to capture the full benefits of the Asian demand opportunity. Most industries are small and yet to transcend niche status. Even the dairy side of the two-speed sector is at risk of losing momentum, while the other side must overcome a number of obstacles to arrest further decline and seize growth opportunities.

Capital constraints preventing growth of value and volume

Substantial growth-oriented capital is needed in Australia and New Zealand over the coming decades. For both countries to grow agricultural exports at the Base Case, described in Chapter 2, around A$600 billion and NZ$210 billion in additional capital will be needed on farms and supply chains between now and 2050, respectively.

A further A$400 billion and NZ$130 billion will be needed to support older farmers exiting the sector, allowing the next generation of farmers to buy them out.

However, traditional sources of finance for farmers – debt and retained earnings – are insufficient:

– Farm debt to asset ratios are already critically high. Over the past decade, Australian dairy and broadacre farmers grew their debt by more than 8% per annum64, while aggregate credit extended to agriculture by New Zealand’s lending institutions grew at 14% per annum.

- Farm equity provides limited additional capital in most industries due to low levels of profitability for the lower performing farmers. In addition to replacement capital, historic data suggests that Australian and New Zealand farms have the capacity to spend around 12% of revenues on growth-related capital expenditure. While this may allow for modest production growth, it is insufficient to support the maximum growth potential of both countries, let alone support farm turnover.

Given the constraints, Australian and New Zealand agriculture will face a capital gap of A$9 billion and NZ$2 billion in the first year of the Base Case (Exhibit 4.3). This translates to a cumulative capital gap of A$515 billion and NZ$110 billion by 2050 (Exhibit 4.4). While these estimates are not forecasts, they illustrate a real and growing capital deficit faced by agriculture today.

Moreover, capital constraints pose serious challenges in all scenarios considered:

- Under the Low Case of export growth, Australia and New Zealand would require an additional capital investment of A$750 billion and NZ$220 billion to drive growth and support farm turnover, but fall short of this requirement by A$360 billion and NZ$60 billion over the years to 2050.

- Under the High Case of export growth, Australia and New Zealand would require an additional capital investment of A$1.6 trillion and NZ$595 billion to drive growth and support farm turnover, but fall short of this requirement by A$850 billion and NZ$220 billion over the years to 2050.

Australia and New Zealand must find answers to questions about where the capital will come from.

The situation is particularly challenging in Australia. Not only is Australia expected to have a much larger capital gap than New Zealand, the nation also has fewer alternative farm ownership and management structures in place to attract capital beyond the farm gate. These structures are critical to providing a credible means to draw investment from capital markets while ensuring farms are managed by high-yielding farmers. Purchasing farms without these mechanisms in place will adversely impact productivity and likely deliver poor returns.

In a world where long-dated capital is increasingly in demand, agriculture in both countries will need to improve returns and find innovative ways to attract investment. The alternatives pathways to address the capital constraints are not attractive: a collapse in land values or delays to farm succession, which can only be sustained in the short to medium term.

Given the sheer scale of the capital required, foreign investors must play a critical role in Australian and New Zealand agriculture over the coming decades, unless major new sources of domestic investment emerge. Strong levels of domestic investment coupled with lower savings rates have meant that both countries have consistently looked to foreign capital to support economic growth.

Since 1980, Australia and New Zealand’s annual ‘savings gap’ has averaged around 4-5% of GDP.

Even with the necessary farm investment vehicles in place, domestic sources alone are unlikely to be enough for agriculture to reach its full potential in Australia and New Zealand.

However, both countries are struggling to find the optimal balance between protecting national interests and attracting foreign capital.

While New Zealand’s regime is seen by some as being too restrictive on foreign agricultural investment, there is increasing concern that Australia’s regime places insufficient scrutiny on such investments. Foreign investment that monopolises supply chains, threatens farm gate pricing, or compromises the taxation base of Australian and New Zealand agricultural output might reasonably attract regulatory attention.

But overly-restrictive regulation, particularly when applied poorly or inconsistently, could substantially deter attractive, productivity enhancing foreign investment.

Both countries face challenges across multiple dimensions:

In New Zealand, while 83% of respondents in an AsiaNZ Research survey felt that Asia is important to the country’s future, another survey by URM Research found 82% of respondents believed foreign ownership in farms and agricultural land was a bad thing.

- The national interest tests used to assess foreign investment lack clarity and transparency in relation to agricultural assets. There is a view that both countries have progressively introduced new investment guidelines on a largely ad-hoc basis in response to a rush of foreign investment, particularly from emerging investors such as Chinese State-owned enterprises. While New Zealand reviews all foreign acquisitions of farmland above 5 hectares, there are also concerns that the threshold to consider foreign acquisitions in Australian farmland are too high (15 per cent or more of an entity valued at A$244 million, indexed annually), allowing most investments to be conducted without regulatory visibility.

- Some argue national interest tests are not efficiently and effectively applied. In New Zealand, the Overseas Investment Office (OIO) is seen to be too slow at reviewing investment proposals with significant inconsistencies in its approach.

- There are ongoing disputes about the transparency and quality of data on foreign investment in agriculture, particularly on trends in farmland ownership. New Zealand has recorded all foreign acquisitions of agricultural assets via the OIO in recent years, it does not have a robust or up-to-date view of the ownership status of all such assets in the country.

It will be critical for both countries to come to a sensible conclusion on how the massive capital gap in agriculture can be filled, particularly for Australia. Inevitably, foreign investment will be an important part of the answer, but the pace of investment cannot get too far ahead of public opinion without undermining its sustainability.

Human and natural resource challenges

Access to and efficient use of key inputs – including labour and natural resources – is critical to the success of agricultural industries. Both countries are now facing serious shortages in their agricultural labour force, while the effective management of land and water is becoming increasingly important.

Growing labour and skill shortages, and ageing farmer populations

Australia and New Zealand both currently face significant agricultural labour and skill shortages, spanning the entire value chain and supporting areas. New Zealand industries struggle to fill on-farm labour needs and more technical positions, including roles in agricultural sciences, are high on the country’s skills shortage lists.

These agricultural labour shortages have already resulted in opportunity costs, particularly in Australia. In recent years, an inability to fill fruit-picking positions has cost each horticultural farm on average $100,000 per annum in unpicked, rotting fruit. Increasing competition for labour from other industries, particularly from Australia’s higher paid mining sector, has added to the pressure.

Compounding these immediate problems, both countries face serious challenges in attracting sufficient talent in agriculture, particularly from the younger generation. This is not only about fostering talented future leaders in farming but across the entire value chain including agricultural extension services, processing and marketing.

Among other indicators, university graduate rates in agriculturerelated disciplines are troubling in both countries.

Over the past decade, Australia has seen a significant drop in the total number of university graduate completions (Exhibit 4.5) and campuses offering agricultural education.

While graduate numbers in New Zealand have remained relatively flat, current levels are not sufficient to meet demand.

New Zealand faces a further challenge of having a large proportion of talent leave the country permanently for overseas opportunities, accounting for as much as 24% of New Zealand-born highly-skilled personnel compared to 3% in Australia.

Moreover, low entry rates into agriculture are especially concerning given the ageing of farmers and agricultural scientists.

Over the past few decades the average or median age of farmers has steadily increased in Australia and New Zealand, and is approaching the mid-50s.

Of further concern is that many Australian and New Zealand farmers do not have formal succession plans in place. For example, a recent ANZ survey in New Zealand found that 71% of farmers wanted to sell their business to the next generation, but only 47% have family working in the business, and only 10% have a formal plan in place.

Management of land resources

In addition to land use optimisation opportunities across different farming enterprises, agricultural land is facing increasing competition from other land uses. High level data suggests that total agricultural land in both countries has decreased over recent decades. In both countries, the rapid expansion of urban centres has contributed to this decline.

In New Zealand, this encroachment has come at the expense of the best agricultural land. In Australia, major mineral and energy resources are also located under some of the most productive farm land creating further conflicts.

While some surveys and research on land use exist, quantifying the extent of any trend is difficult given that agricultural land use data for both countries is inconsistent and not sufficiently comprehensive. It is clear that more focus is needed in both countries to understand and manage conflicts in land use, particularly given that the current uncertainty could discourage growth-oriented investment by some farmers.

Management of water resources

Effective management of water resources is critical. Water markets in both countries are challenged by varying degrees of inefficiency in allocation, trading and use.

Compared to Australia, New Zealand’s water use governance is less developed, with a comprehensive policy yet to be implemented.

To date, New Zealand has struggled to set and manage limits on water use, despite intensive agricultural expansion, with the result being deterioration in water quality.

The country is yet to develop a flexible means of allowing water permits to be allocated and transferred among users. Monitoring and enforcement of rules and consents are inconsistent as are water policies and planning processes. There are also concerns that councils governing water have insufficient resources and governance skills.

These challenges have been recognised, with positive progress, but much more needs to be done. Moreover, industry surveys have suggested that there is widespread consensus that New Zealand still does not fully recognise the economic and social benefits that more extensive irrigation infrastructure can bring to the economy.

Proposed schemes to date are often small, hobby projects being run by passionate farmers; lacking a wider vision and the necessary governance skills to bring larger projects to fruition.

Research and development funding needs new focus and efficiency

Sufficient and targeted R&D is crucial to maintaining international competitive advantage in agriculture.

There is currently a need for greater clarity around the extent and balance of agricultural R&D investment in Australia and New Zealand, particularly in new high potential opportunities.

Notwithstanding various attempts to gauge the adequacy of total agricultural R&D spending in Australia and New Zealand, none of the studies to date have provided a compelling basis to draw conclusions.

In contrast to Australia, New Zealand seems to be more focussed on larger, game changing research, but may need to consider more adaptive research from developments abroad given its scale.

It may also benefit from a greater emphasis on market-focussed research to increase returns through capturing greater price premiums, rather than relying purely on volume growth.

Clearly, no single solution fits all – each country holds unique strengths and challenges that need to be addressed via a tailored approach.

The contribution of the private sector in R&D investment has been a cause for concern in Australia and New Zealand. While the share of private sector expenditure has increased in both countries over recent decades, levels are still significantly below other high-income countries, particularly outside of food processing. Industry collaboration with research institutions may also be insufficient, and possibly in decline.

Crown Research Institutes (CRIs) in New Zealand have also been challenged by similar issues. Heavy reliance on short term contestable funding made it difficult for them to operate strategically and to adopt best-practice research management techniques.

Multiple lines of accountability also created confusion and contributed to staff morale issues. While recent CRI reforms have sought to address these challenges it is still too early to assess their success.

More extension services needed to support farm performance

To achieve improvements in agricultural production, effective R&D outcomes need to be accompanied by sustained and widespread adoption of new technologies and best practices. Today, there are substantial variations in performance among farms in Australia and New Zealand, with signs that the gaps have been widening in recent decades. Agricultural extension services play a critical role in driving ongoing farm improvements and closing the performance gaps. There are growing concerns that these services are not currently sufficient and possibly in decline in both countries.

Similarly, industry bodies in New Zealand such as Dairy NZ and Beef & Lamb NZ have found large variations in profitability between the top farms and others in their respective industries. In each case, the performance differences were driven by increased abilities to use inputs efficiently and deliver higher yields.

It is clear that there is scope for improving extension services in both countries.

In New Zealand, a recent study by KPMG highlighted an industry view that the agricultural extension system has not worked effectively since it was privatised in the late 1980s. While the reduction of public sector involvement in extension could, in theory, create a market for private operators with superior, client-specific services, it could also adversely impact productivity – where quality gains do not justify the increase in cost. Whether the best answer is to make private services more effective, or to provide more public services, will need further debate.

Supply chain challenges and unfinished policy reforms

The history of agriculture across the globe contains many examples of supply chain failure of one sort or another. Typically, failure falls into one of three categories.

1. The supply chain is too immature to support marketing and movement of large volumes of products into end user markets.

2. Supply chains become monopolised, particularly if the product is perishable or expensive to move relative to the value of the product.

3. A loss of trust and coordination between participants in the supply chain results in persistent underinvestment.

For example, in response to receiving unfavourable terms from processors, farmers halt or scale back production. This in turn creates overcapacity downstream and discourages further investment by processors.

Importantly, supply chain failures hurt the competitive position of industries, particularly in cost, and constrain the potential for future growth.

These issues are less evident when there is significant competition at each stage of the supply chain, or when there are high levels of alignment, particularly through supply chain ownership by farmers. This might involve, for example, well-run farmer owned cooperatives controlling processing or infrastructure assets. While market structure alone cannot completely mitigate supply chain failures, some models are more effective at supporting industry alignment and fostering growth than others.

Government regulation can also help, but is rarely enough to achieve a robust outcome with ongoing incentives to invest.

Australia and New Zealand have come a long way in removing regulation and encouraging competition within key agricultural industries. Recent decades saw the removal of industry-distorting subsidies, deregulation of markets and the removal of single desk marketing boards.

These reforms had the intention of making industries more efficient and globally competitive – and there is no doubt the changes have created huge success stories: New Zealand’s dairy industry being an example. However, there is more work to be done to fully realise the original goals driving the reforms. In Australia, the deregulation, privatisation and consolidation of some supply chains have replaced heavy-handed government ownership with control by a small number of providers. There still remains some unfinished business that could unlock the full potential of some of the largest agricultural industries in both countries.

In Australia, declining supply chain performance is putting competitiveness at risk in some industries.

Where there is high concentration of downstream ownership in supply chains not owned by farmers, regulators and farmers need to be vigilant.

As described in Chapter 3, New Zealand dairy has done a good job of maintaining an aligned supply chain in a challenging industry. While Fonterra has a market share greater than 90%, its farmer-owned cooperative structure enables it to achieve scale efficiencies across the supply chain while maintaining alignment with its farmer shareholders.

The deregulation process also promoted contestability and allowed a series of competitive fringe processors to emerge. Although cooperatives are not the only model capable of fostering growth, where they are well run they foster an environment that incentivises all supply chain participants to work together towards industry growth.

Other industries in New Zealand face supply chain issues, in some cases because of excessive fragmentation.

The performance of the red meat industry has been attributed to the inefficient procurement model between farmers and processors and the lack of coordination in the marketing and selling of products overseas.

Overcapacity at the processor stage has caused excessive competition for supply, eroding profitability and the ability to make long term decisions.

Farmers in turn are hampered by unclear market signals from processors and a lack of direction for change, such as when to make expansion decisions, impacting confidence to invest.

Limited progress in furthering access to key markets

Australia and New Zealand have historically increased global market access through free trade agreements (FTA). While significant progress has been made by both
countries, more can be done to enhance access to high-value markets, particularly for Australia.

Australia has yet to reach a free trade agreement with China after 18 rounds of negotiations. First initiated in April 2005, approximately six months after the New Zealand-China talks commenced, progress on Australian negotiations have stalled. Disagreements have been primarily over Australian agriculture gaining the same level of access to Chinese markets as New Zealand. An FTA with China would bring substantial benefits for Australia.

Since New Zealand’s FTA with China came into force in October 2008, the growth rate of New Zealand’s agricultural exports has tripled to 38% per annum128. Australia and New Zealand are also independently in trade negotiations with India, but neither have yet to come to an agreement.

Moreover, further work could be done by Australia and New Zealand to explore more innovative ways to increase market access beyond FTAs. Key growth markets such as China are increasingly concerned about food security. This has led them to pursue investments in foreign farmland and agricultural companies.

In recent years, tightening land ownership policies around the world, for example in Brazil and Argentina, have led China to shift its strategy to securing strategic off-take agreements. These agreements involve investment in farm, processing or logistical infrastructure in return for output, without the need for ownership.

In addition to activities in Brazil, 2011 saw an agreement between Chinese SOE Beidahuang and Argentina’s Rio Negro Government. The agreement involved the investment of US$1.5 billion in return for agricultural exports over the next 20 years. The capital will go towards developing 300,000 hectares of marginal farm land
(without ownership) to produce wheat, corn, soybeans, fruit, vegetables and wine, and to expand a power plant and port for shifting produce to China.

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This story has been adapted from Part 4 of the ANZ report: Greener Pastures: The Global Soft Commodity Opportunity for Australia and New Zealand (.pdf 13MB)

Here is Gareth Vaughan's interview with ANZ's Graham Turley.

Part two deals with the global soft commodity opportunity and you can read that part here »

Part two deals with the global soft commodity opportunity and you can read that part here »

Part three deals with the building competitive advantage in key markets and you can read that part here »

Part five will follow next week. It reviews how we can unlock the full potential of our agriculture.